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To the dismay (and ongoing annoyance) of many colleagues – yes, you know who you are – I’ve spent years pushing back on the casual use of the term “Intentionally Defective Grantor Trust” (“IDGT”).

Used incorrectly, it can be dangerous.

An “IDGT” is typically understood to mean a trust that is:

• Complete for gift tax purposes (assets are out of the estate), and
• Defective for income tax purposes (the grantor still pays the income tax)

Certain retained powers (think: power of substitution) can create this split treatment.

And yes, when done correctly, there are real planning benefits.

Here is the trap:

Not every irrevocable trust is a completed gift!

So what? It’s just semantics, right?

Here is an example:

Helen was worried about her ability to manage her assets as she got older and was faced with some health issues. Her attorney recommended putting assets into an irrevocable trust for her benefit and hiring a trust company as trustee to manage the assets and to help her with budgeting.

The well-intentioned associate at the trust company onboarding her account saw:

“Irrevocable trust + grantor trust = IDGT.”

And coded it that way.

What could go wrong?

The assets were primarily low-basis, highly appreciated stock (read: built-in gain). You see where this is headed?

On Helen’s death, the trust assets were to be distributed to her nieces and nephews. Because the trust was coded as IDGT, the associate handling the trust on Helen’s death assumed the assets were not entitled to a step-up in basis (in his defense, a true IDGT is not entitled to a step-up). Therefore, the trustee made no basis adjustments, and the nieces and nephews inherited a whole lot of built-in capital gain.

In reality, Helen’s trust was never a completed gift and therefore never a true IDGT. The assets were entitled to a step-up in basis. The nieces and nephews should receive those assets with a fair market value basis, and no gain.

Say it with me: “it’s not an IDGT unless you know for sure it was a completed gift”!

If not, it’s an irrevocable grantor trust. The distinction matters.

What do you think? Do you see this happen in your organization where shorthand terminology leads to incorrect administration or tax decisions?

To learn more, or if you would like a second set of eyes on a trust structure or administration approach, please reach out: www.blackbirdtrust.com or via email at [email protected].

For educational purposes only, not to be construed as legal or tax advice.

You drafted a trust specifically to avoid probate. And yet…your trustee may still have to open probate. It could happen!

Here’s how:

Mike and Carol are a wealthy, married couple with six children (Carol’s three daughters are from her previous marriage, and Mike’s three sons are from his previous marriage).

They hired Attorney Alice to craft a tidy and thorough estate plan, including a joint revocable trust. They fully funded the trust during their lives. One of their main goals: avoid probate.

The trust sings a familiar tune – at the death of the first spouse, assets remain in trust for the benefit of the surviving spouse and, at the surviving spouse’s death, the assets are split equally amongst their six children… that is, unless the surviving spouse exercises his or her power of appointment.

A power of appointment allows the surviving spouse (or other powerholder) to redirect the assets, often to protect a beneficiary or to adjust for changing circumstances.

For example, what if Mike’s youngest son, Bobby, is facing some legal or creditor troubles? The powerholder could appoint Bobby’s share of the assets into a discretionary trust for his benefit, which provides creditor protection, instead of going outright to him, where it could land in the hands of a divorcing spouse or a creditor.

Attorney Alice included the traditional testamentary power of appointment language in Mike and Carol’s trust document.

It goes something like, “upon the surviving spouse’s death, the remaining trust principal shall be distributed to such person or persons, excluding his or her estate, as the surviving spouse may appoint by a will that specifically refers to this power of appointment.”

It’s boilerplate language. Everyone includes that, right? What could go wrong?

Mike died a few years ago. Sadly, Carol just died.

The question for the fiduciary now in charge: who is entitled to the trust assets?

Obviously, it’s the six children equally, right? Maybe.

Mike’s oldest son, Greg, has presented the trustee with Carol’s will. In this will, Carol fails to exercise her power of appointment. Mike and Carol were careful to title all of their assets in trust, with the specific goal of avoiding probate, so Greg has no intention of opening an estate with the local probate court.

Here is the trap. Carol has a power of appointment. It can only be exercised in her will. And a will isn’t “real” until it’s been proven or validated by a probate court. So, even though everything was titled in trust, the trustee may still need to open a probate!

The conservative and careful trustee is going to worry about, for example, whether Carol executed a newer will prior to her death that appoints the entire trust to her daughters, Marsha, Jan, and Cindy, instead of all children equally. The best protection for the trustee is likely to go through the probate process to prove Greg’s version of the will is the right one.

This process takes time and costs money. And it was exactly what the trust was designed to avoid.

This is a bad result. How do we avoid it?

First, if you’re at the drafting stages, it’s easily avoidable. In the power of appointment language, clarify that the will need not be formally probated, or include the option to exercise the power in any separate, notarized writing.

If it’s too late and the trust is irrevocable, depending on the facts and local law, you may consider a quick modification, either by nonjudicial settlement agreement or otherwise. In any event, it may be helpful to know in advance in order to manage clients’ expectations. They may need to open an expedited probate.

This is an easy issue to miss, but an important one to catch early.

What do you think? Do you see this happening with any of your clients?

To learn more, or if you need help analyzing your documents to identify potential issues like this, please visit my website at www.blackbirdtrust.com or send me an email at [email protected]. I would be happy to take a look and discuss.

For educational purposes only, not to be construed as legal or tax advice.